Eat the Loan Sharks!

Let's solve the subprime mess by going after lawbreaking lenders.

In early October, Bank of America quietly entered into the largest settlement in history to make amends for predatory lending, putting up more than $8 billion to rescue borrowers with faulty loans from Countrywide Financial, a notorious subprime lender recently purchased by the bank. As politicians and regulators haggle over the best approach to modify perilous mortgages and as millions of Americans fall deeper into delinquency, the Bank of America settlement offers a clear path out of the broader problem: Chuck the illegal loans and start over again, making the lawless lenders foot the bill.

Part of the backdrop here is dismayingly familiar. Explosive growth of subprime lending created perverse incentives that led to fraudulently inflated loan terms. What's less known is that some of these loans were priced higher based on the race of the borrower, with African-Americans and Latinos paying more, in secret, behind-the-scenes deals. Some of this activity will even turn out to have been criminal. There are more than 1,500 open FBI investigations into mortgage fraud, much of it concentrated in the subprime market.

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At the same time, many delinquent borrowers don't know that the terms of their home mortgages may have been the byproduct of fraudulent, discriminatory, or criminal behavior by mortgage brokers and lenders. Before we end up spending billions to rescue subprime borrowers, we should figure out which loans were the products of illegal behavior, rescind them, and rewrite them on terms that are fair and legal. If there is a cost associated with this process, let lenders pick up the tab, which is precisely what Bank of America is doing. This would save taxpayer money by reducing the number of loans that the government would pay to modify. It would also help to stabilize the housing market and lay the blame for much of the subprime crisis at the feet of those most responsible: the lenders who acted like predators.

What's the evidence that African-Americans and Latinos paid more for loans in a way that's illegal? A study of lending data from 2006 by the Federal Reserve estimates that roughly 18 percent of the loans made to white borrowers in that year were subprime loans, compared with roughly half the loans made to African-Americans and Latinos during that time. When the study assessed borrowers of similar incomes, 30 percent of African-American borrowers received subprime loans, compared with 18 percent of whites and 26 percent of Latinos. These discrepancies aren't absolute proof, but they suggest that discriminatory steering took place in which otherwise qualified borrowers of color were directed to subprime, and substandard, loans. Federal law makes it illegal to discriminate based on race in the terms and conditions of a home mortgage loan. It would appear that this is exactly what happened.

This discrimination is at the core of a number of lawsuits advocates have filed across the country over the last year. Several of the cases focus on a particularly devious practice: Without borrower knowledge, many mortgage brokers received a commission from the lender for persuading a borrower to accept a higher loan interest rate than what the bank was otherwise willing to offer. The lawsuits claim that such commissions were paid more often in loans to African-Americans and Latinos than in loans to whites, revealing, again, that lenders often charged borrowers of color more than their white counterparts. As these suits progress, and the groups suing gain access to lenders' and brokers' records—e-mails, internal memoranda, training materials, and other documents—we are likely to learn more about the practices of the lenders who are the defendants and about the industry in general.

Discriminating lenders were not the only problem with the housing market that courts should now address. Mortgage brokers rushed into poor communities with exotic subprime loans during the early part of this decade, because these communities were underserved by traditional banks. During the height of the market, nearly half of all subprime loans went through a broker, compared with only 28 percent of prime loans. Brokers also dominated loans made to borrowers of color: 64 percent of African-American borrowers used a broker, compared with only 38 percent of white borrowers.

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The problem with this wasn't the mortgage brokers per se. It was that many prospective borrowers wrongly assumed that the brokers were working in the borrower's best interest. But in most states, mortgage brokers do not owe any duty to the borrower to find the best possible deal. Many brokers relied on borrowers' ignorance of the mortgage market to pursue higher commissions and other financial perks for themselves. In much of the country, there's no legal remedy for this. But a few states require that brokers avoid conflicts of interest and pursue the best deal for the borrower. These states include California, home to about one-quarter of the mortgages in the United States that are in some stage of foreclosure. The Department of Justice, the state attorney general, legal-services attorneys, volunteer lawyers, and law students should all be poring over California loan documents to smoke out the brokers who violated their legally mandated duties to their clients. If a significant number of loans in California alone could be altered, consistent with the borrowers' abilities to pay, either through litigation or its threat, the federal government wouldn't have to pay as much for a national bailout.

To date, none of the proposed homeowner-rescue plans acknowledges that a significant number of the homeowners who are in distress were the victims of predatory and illegal practices. Opponents of the plans currently on the table raise three serious objections: First, any massive loan rescue would be costly; second, borrowers in good standing might intentionally default on their mortgages to benefit from a bailout; and third, investors holding securities backed by subprime loans will balk at loan modifications that diminish their already depreciated investments and will sue to stop such efforts.

Going after the lawbreakers helps to address these concerns. It would not only lower the cost of the rescue plan by reducing the number of borrowers needing help, it would also direct assistance only to those people who were victims of illegal conduct and insulate the loan modifications from litigation by investors looking to preserve their investments. Investors won't challenge loan restructuring when the underlying loans were made on illegal terms. You don't lend your horse to Jesse James and then sue the stagecoach he robbed to get it back. Investors will have to redirect their fire from the borrowers to the brokers and lenders who did the fancy loan footwork—and perhaps the ratings agencies that blessed it.

Some investors will have to line up in bankruptcy court, since more than 40 subprime lenders have gone belly up in the last two years. But there are some still standing, like Wells Fargo (already facing a discrimination lawsuit brought by elected officials in Baltimore). And where federal and state investigations have already netted criminal indictments in cases of broker and lender fraud, civil liability should follow. Lax enforcement of the laws is clearly one of the many reasons we find ourselves in the current mess. Strict enforcement of those laws would help get us out of it.

Ray Brescia is a visiting assistant professor of law at Albany Law School.